How to calculate the current ratio and why is it important | ApnaCourse

Manu! I am sick of our Bankers! They denied working capital loan to our company by just quoting one ratio.

Manu

What was that Vinu?

Vinu

They said our current ratio is very low and so they are not interested in funding our company.

Manu

Ohhh…..

Vinu

How can they talk like that?

That too just by looking at single ratios?

Unfair!!!!

Manu

Vinu! Don’t blame the bankers. They are just agents of public. If they are quoting a particular ratio as the main reason to deny the loan, then it sounds very serious. i.e., your company has to work on certain things very seriously now.

Vinu

Our company has long years of experience and presence in the market. I don’t see any problem with our company.

Manu

No Vinu! If Banker is not happy with your financial ratio, then your company should seriously work on it. Because, all most all the companies in the country or for that matter, in the world, works predominantly with Bankers funds. So, if a Banker is not satisfied with your financial ratios, then you have not equipped to the expectation of the major stake holder. This will affect the future direction of the company. You may not get timely fund and you may not be able to grow!!

Vinu

I agree Manu!

Manu

Moreover, bank funds are supposed to be the cheapest funds in view of its tax benefits. So you have to work on it.

Vinu

Ok! Tell me where we should work on?

Manu

First tell me that ratio, which bankers are not comfortable with.

Vinu

It is our Current Ratio of 0.87.

Manu

My Goddd…..I fully support that banker.

Vinu

Why????

Manu

You are in a Financial mess now. How can you expect a banker to support you at this stage?

Vinu

Can you explain clearly?

Manu

Vinu. Your current ratio is 0.87

Vinu

Yes

Manu

It is at its dangerous level. Do you know how current ratio is calculated?

Vinu

Yes! Very simple

Current Ratio = Current Asset / Current Liability

Manu

Yes! Calculation is very simple. But implications are very serious.

Vinu

What’s wrong with our ratio?

Manu

Your ratio is 0.87

It means,

-for every Re.1 of Current Liability (short term liabilities),

-you have Re.0.87 of Current Assets (short term resource)

Vinu

What’s problem in that?

Manu

It is the problem.

Your liability is Re.1 and for paying that liability you have only Re.0.87 with you.

On the face, you don’t have sufficient money to pay even Re.1 fully. You are short by Re.0.13. Then how you will be able to pay the banker in Crores.

This ratio says, you have borrowed more and you don’t have adequate cash resources to pay back.

This also would mean, some short term creditors are angry with you, because you don’t have adequate cash, and so they may file case against your company for non payment!

This may go even go up to liquidation of company through court order!

Vinu

My Goddd…..…Is it so serious?

So do you mean to say, we should have current assets matching current liability?

Manu

If you have current assets = current liability, your current ratio will be 1:1.

But still banker will not be happy

Vinu

But why?

Manu

Because, sometimes, certain current assets will not be available for paying of your liabilities immediately

Vinu

Like?

Manu

Like Inventory, delayed debtors, etc.

Vinu

So?

Manu

So, banker will be expecting you to have more current assets.

It means, you will have more resources to pay off your liabilities.

Vinu

Ok!

Manu

Only when you have more resources and less liabilities, your liquidity position is said to be comfortable!

Vinu

Yes! Now I understand, why our current ratio is very low?

We purchased all most all our products on credit. So we had high level of Creditors. This had inflated the current liability.

Since we purchased everything on credit, we had surplus cash, which we have invested in fixed assets which will take some more time break even and come back to us through profits.

Manu

Since you have converted your cash into fixed assets, your current asset level also have come down.

On one side, your current liabilities have gone up and on the other side, your current assets have come down.

Lower numerator and higher denominator has resulted in very low ratio for your company.

Vinu

Yes Manu!

Manu

It means, your company should be facing difficulty in making payments like salary, creditors, is it not?

Vinu

Yes Manu L

Manu

It is because, you have sourced lot of short funds (creditors) and in turn used them for long term purposes. You cash got locked in Fixed Assets which will not come back to you in short cycle.

But your creditors will start asking for payments.

So whatever cash realised will go to them and eventually it will affect even the salary payment.

Vinu

True!

Manu

These are the very common implications of lower current ratio which that banker had identified just looking at the number of 0.87.

If the ratio is less than 1.00, we can presume all the above.

Vinu

So, how a current ratio should be?

Manu

Current asset should be greater than current liabilities.

Theoretically, 2:1 is considered as ideal current ratio.

But Banker will be happy, if your current ratio is at least 1.33

Vinu

What is that 1.33?

Manu

It means, for

Every Re.1 of Current Liability, you should have Re.1.33 of Current Assets!

Vinu

I understood that! But what’s special in that?

Manu

You calculate the proportion of current liability to current assets at that level

Vinu

Current liability – 1.00

Current assets – 1.33

Current liability (1/1.33) is 75% of Current Assets.

Manu

Yes!

Exactly.

At current ratio of 1.33, you are funding 75% of current assets through current liability.

It automatically conveys something else.

Vinu

Hmmm??

Remaining 25%?

Manu

Yes!

It means remaining 25% is funded by ………..

Vinu

By???

Manu

What is known as ‘NETWORKING CAPITAL’

Vinu

Yes.

Current Assets – Current Liability = Net Working Capital

Manu

True!

So when your ratio is 1.33, it means, you are contributing 25% to your business through Net Working Capital and it is the least expectation of any banker.

i.e., Bankers are ready to fund 75% for Working Capital, provided Owner contributes at least 25% of funds and it is demonstrated through 1.33.

Vinu

Great….and Thank you Manu!

I never thought Current ratio will convey so many things!

Thanks again.

Manu

Welcome Vinu!

N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.